1. Monetary policy Gene H Chang University of Toledo

2. The money multiplier again  Ms Money multiplier (  m ) = ---------  H Ms  Ms =   m X  H

3. Money Supply, February 2002 Copyright © 2003 South-Western/Thomson Learning. All rights reserved. M2 = $5500 billion M1 = $1183 billion Money market mutual funds $972 billion Savings deposits $3345 billion M1 $1183 billion Checking deposits in commercial banks $324 billion Other checkable deposits $268 billion Currency outside banks $591 billion

4. Money and Income are different  When you say “I want to make a lot of money”, you actually mean “income”  A person can be wealthy but have little money

5. Monetary base  Monetary base  Also called High power money (H)  Consists of currencies and other reserves in the central bank.

6. Who controls the monetary policy?  Who controls H?  Who is responsible for the monetary policy in the U.S.?  The Federal Reserve System (Fed)  It is actually the central bank in the U.S.

7. Federal Reserve Bank

9. The Federal Reserve System (Fed)  Board of Governors of the Fed  Federal Open Market Committee  Fed is independent

10. America’s Central Bank: The Federal Reserve System  The Federal Reserve System, established in 1914, is the U.S. central bank. –Comprised of twelve district banks –Governed by a seven-member Board of Governors –Decisions on the money supply made by the Federal Open Market Committee –Normally meet 8 times a year, but can be more.

11. The Federal Reserve System  Fed’s Independence –Fed board members:  Appointed to fourteen-year terms  Independent of political pressures –Federal Open Market Committee  12 members. 7 governors + 5 presidents of Fed district banks.

12.  Central Bank Independence –In some other countries, the central banks are less independent. –They have to listen to the government –Countries without independent central banks often have less stable macro- economies such as running a high inflation. America’s Central Bank: The Federal Reserve System

13. How does the Fed control money supply?  Open Market Operation (OMO)  Change in discount rate  Change in RRR

14.  Fed changes M by OMO  The Fed can increase the money supply by buying government securities on the open market. –It pays the commercial banks for these securities. –This injects additional reserves to the commercial banks – like you deposit cash in Bank A –  multiple expansion of the money supply. Open Market Operation (OMO)

15.  To reduce the money supply, the Fed sells securities on the open market. –The commercial banks pay their reserves for these securities from the Fed. –This reduces reserves the commercial banks have – multiple deduction of the money supply Open Market Operation (OMO)

16. Open Market Operation  Open Market Operation (OMO) –Fed buys bonds ----- Ms rises –Fed sells bonds ----- Ms falls  Open Market Operation is the most important measure to control money supply thus meeting the interest rate target.

17. Open Market Operation  Conducting OMO, the Fed can reach its interest rate target: –buy bonds ----- Ms rises --- interest rate down –sell bonds ----- Ms falls --- interest rate up

18. Change in discount rate Change in discount rate  Discount Rate is the interest rate the Fed charges on loans it makes to commercial banks.  Increase in the discount rate will discourage banks to borrow money (reserve) from the Fed.  Reduce in the discount rate will encourage banks to borrow money (reserve) from the Fed.  It directly affects the interest rate in the market.

19. Change in Required Reserve Ratio (RRR) Change in Required Reserve Ratio (RRR)  Changes in RRR  Money multiplier changes    m = 1 / RRR    Ms =   m X  H  Then money supply changes

20. Inverse relationship between money supply and interest rate Inverse relationship between money supply and interest rate  Determination of the market interest rate  The money market diagram

21. The money market diagram Money (M) 0 Interest rate (r) MsMs MdMd r* M*

22. Money supply curve Money supply curve  Money supply curve. –slopes upward, for simplicity, vertical  What shifts the Money supply curve? (determinants of Ms)  Mainly, the Fed's increase or decrease of H.  Then changes Ms.

23. Money Demand Money Demand  Definition and clarification.  That is your demand for liquidity.  It is very different from the ordinary usage!  When you say “I want a lot of money” in the ordinary usage, you mean that you want high income or to be wealthy.  That is different from “demand for money” in economics!

24. Money Demand Money Demand  Demand for money is demand for medium of exchange  Or, roughly, demand for cash for the transaction purpose  It is a portfolio decision  You have to weigh between two options of holding money or holding bonds

25. Money Demand Money Demand  You have to weigh between holding money or holding bonds  Money gives you the convenience to buy things, but it does not yield interest.  The opportunity cost of holding money is sacrificing the interest income.

26. Money Demand Money Demand  Government securities (bonds) are just opposite.  You earn interest from holding bonds  But bonds are not medium of exchange  you cannot buy things or pay bills by bonds

27. Money demand Bonds Given amount of Wealth Money

28. Money Demand and interest rate Money Demand and interest rate  If interest rate goes up  Bonds are more attractive and holding money is more costly  Quantity of money demanded goes down

29. Money Demand and interest rate Money Demand and interest rate  If interest rate goes down  Bonds are less attractive  Holding money gives more convenience  Quantity of money demanded goes up

30. Money Demand and interest rate Money Demand and interest rate  Therefore an inverse relationship between quantity of money demanded (Md) and interest rate (r)  The money demand curve slops downwards

31. Shifters of Money Demand Shifters of Money Demand What shifts the money demand curve?  Income level –Income goes up, needs more money to buy things.  Price level –Price goes up, for the same amount of transactions, needs more money to buy the same amount things.

32. The money market diagram Money (M) 0 Interest rate (r) MdMd r* M* MdMd

33. Clarifying the concepts  Quantity of money demand  Money demand  Movement versus shift

34. Equilibrium in the money market  Intersection of Md and Ms

35. The money market diagram Money (M) 0 Interest rate (r) MsMs MdMd r* M*

36. Comments on the interest rate on the money market  Intersection of Md and Ms  Fed can control Ms but not Md  Fed can set a target for interest rate by conducting OMO and amount of money for the Fed funds rate.  Because Md shifts, the market rate may deviate from the Fed target.

37. Difference between market and Fed rates. Federal Funds Data, 2006 DATEDAILY 1 RANGE STD. DEV. TARGET RATE LOWHIGH 11/20/20065.255.195.50.055.25 11/17/20065.255.3750.185.25 11/16/20065.2555.3750.025.25 11/15/20065.2955.3750.035.25 11/14/20065.255.1255.3750.025.25 11/13/20065.275.1255.50.055.25 11/10/20065.235.062560.055.25 11/09/20065.235.155.3750.025.25 11/08/2006*5.2255.750.045.25 11/07/20065.2255.50.045.25 11/06/20065.2455.3750.035.25

38. The current rate This weekMonth agoYear ago WSJ Prime Rate 3.25 Federal Discount Rate 0.75 0.50 Fed Funds Rate (Current target rate 0- 0.25) 0.25

39. Equilibrium in the money market  What happens if the economy is growing rapidly? –Money demand up and interest rate up  What happens if the government spending increases rapidly? –Money demand up and interest rate up  What happens if the price goes up –Money demand up and interest rate up

40. The money market diagram Money (M) 0 Interest rate (r) MsMs MdMd r* M* MdMd r’

41. Equilibrium in the money market  What happens if the Fed increase money supply –Money supply goes up –Interest rate goes down

42. The money market diagram Money (M) 0 Interest rate (r) MsMs MdMd r* M* M s’ r’

43. Cases  The low interest rates in 1992-95 and 2002-2004  1982-83, the interest rate surged to 20%. What was the reason? Reagan and Fed’s policies  Bush’s budget deficit adds pressure on the interest rate.  2008-2009, easy money and low interest rate.  Fed discount rate: 0.75. Fund rate: 0.25%  Nov. 2010, Fed buy 600b bonds

44. Fed funds rate (interest rate)

45. The case in 1982-83 Money (M) 0 Interest rate (r) MsMs MdMd r* M* MdMd r’r’ Fed Tax cut

46. Equilibrium in the money market  What happens if the price goes up moderately –Money demand up  What happens if the inflation accelerates to a hyperinflation? –Money demand goes down because people want to avoid the loss by holding money  Difference between Price and Inflation  Like the difference between distance and speed

47. OMO: Relationships among Ms, bond price and interest rates When the Fed buys bonds:  Money supply increases  demand for bonds  price of bonds   interest rate Opposite when Fed sell bonds

48. Goals of the monetary policy by the Fed  Stable price  Economic growth and full employment  Stable interest rate

49. How the monetary policy affect the economy  Monetary expansion  Ms increases   r falls   Investment rises   AE shifts up   AD shifts to right   Y and P rises

50. How the monetary policy affect the economy Money (M) 0 Interest rate (r) MsMs MdMd r* M* M s’ r’

51. How the monetary policy affect the economy Monetary expansion (b) Price (P) GDP (Y) (a) Aggregate Expenditure (AE) GDP (Y)Y* 0 1 45 E 0 E 0 AE’ (I 1 ) E 1 AE(I 0 ) I ↑ P0P0 AD Y’ 1 E1E1 AD’ Y’ 0 AS E2E2

52. How the monetary policy affect the economy (b) Price (P) GDP (Y) E 0 P0P0 AD 2 E1E1 AD’ Y’ 0 AS E2E2 Y P2P2

53. How the monetary policy affect the economy  Monetary contraction  Ms decreases   r rises   Investment falls   AE shifts down   AD shifts to left   Y and P falls

54. Is monetary policy effective?  Controversy  Keynesian view  May not be effective in depression, as people are pessimistic –Liquidity trap –Investment is insensitive to a lower interest rate

55. Is monetary policy effective?  In addition, a monetary policy may be ineffective because: –Time lag is longer –Magnitude is unpredictable

56. Is monetary policy effective?  The Monetary school  Milton Friedman